Basic Introduction Securities Lecture 3 Course code MBF

Basic Introduction Securities Lecture: 3 Course code: MBF 702

Outline • • • Securities Non marketable securities Marketable securities Forms of Marketable securities Indirect investments Securities and risks

Securities ”A legal contract representing the right to receive future benefits under a stated set of conditions. ” • The piece of paper (e. g. the share certificate or the bond) defining the property rights is the physical form of the security. The terms security or asset can be used interchangeably. If a distinction is sought between them, it is that the term assets can be applied to both financial and real investments whereas a security is simply a financial asset. For much of the analysis it is asset that is used as the generic term. • From an investor’s perspective, the two most crucial characteristics of a security are the return it promises and the risk inherent in the return. An informal description of return is that it is the gain made from an investment and of risk that it is the variability in the return.

Securities • • More precise definitions of these terms and the methods for calculating them will be discussed later. For the present purpose, the return can be defined as the percentage increase in the value of the investment, so

Securities • The return on a security is the fundamental reason for wishing to hold it. The return is determined by the payments made during the lifetime of the security plus the increase in the security’s value. The importance of risk comes from the fact that the return on most securities (if not all) is not known with certainty when the security is purchased. This is because the future value of security is unknown and its flow of payments may not be certain. The risk of a security is a measure of the size of the variability or uncertainty of its return. • It is a fundamental assumption of investment analysis that investors wish to have more return but do not like risk. Therefore to be encouraged to invest in assets with higher risks they must be compensated with greater return. This fact, that increased return and increased risk go together, is one of the fundamental features of assets.

Securities • A further important feature of a security is its liquidity. This is the ease with which it can be traded and turned into cash. For some assets there are highly developed markets with considerable volumes of trade. These assets will be highly liquid. Other assets are more specialized and may require some effort to be made to match buyers and sellers. All other things being equal, an investor will always prefer greater liquidity in their assets.

Non marketable securities • • The first form of security to introduce are those which are non-marketable, meaning that they cannot be traded once purchased. Despite not being tradeable, they are important because they can compose significant parts of many investors’ portfolios. The important characteristics of these securities are that they are personal - the investor needs to reveal personal details in order to obtain them so that the parties on both sides know who is involved. They tend to be safe because they are usually held at institutions that are insured and are also liquid although sometimes at a cost. One form of such security is the savings account. This is the standard form of deposit account which pays interest and can be held at a range of institutions from commercial banks through to credit unions. The interest rate is typically variable over time. In addition, higher interest will be paid as the size of deposit increases and as the notice required for withdrawal increases.

Non marketable securities • Another form of such investment is government saving bonds. These are the nontraded debt of governments. The bonds receive interest only when they are redeemed. Redemption is anytime from six months after the issue date.

Marketable securities • Marketable securities are those that can be traded between investors. Some are traded on highly developed and regulated markets while others can be traded between individual investors with brokers acting as middle-men.

Forms of marketable securities • This class of securities will be described under four headings. They are classified into money market securities which have short maturities and capital market securities which have long maturities. The third group are derivatives whose values are determined by the values of other assets. The final group are classified as indirect investments and represent the purchase of assets via an investment company.

Money marketable securities Money market securities are short-term debt instruments sold by governments, financial institutions and corporations. The important characteristic of these securities is that they have maturities when issued of one year or less. Money market securities tend to be highly liquid and safe assets. Because of the minimum size of transactions, the market is dominated by financial institutions rather than private investors. One route for investors to access this market is via money market mutual funds.

Money marketable securities • Treasury Bills Short-term treasury bills are sold by most governments as a way of obtaining revenues and for influencing the market. As later chapters will show, all interest rates are related so increasing the supply of treasury bills will raise interest rates (investors have to be given a better reward to be induced to increase demand) while reducing the supply will lower them. Treasury bills issued by the federal government are considered to be the least risky and the most marketable of all money markets instruments. They represent a short-term loan to the federal government. The federal government has no record of default on such loans and, since it can always print money to repay the loans, is unlikely to default. Treasury bills with 3 month and 6 -month maturities are sold in weekly auctions. Those with a maturity of 1 year are sold monthly.

Money marketable securities An important component in some of the analysis in the later discussion is the risk-free asset. This is defined as an asset which has a known return and no risk. Because Treasury Bills (and those of other governments with a similar default-free record) are considered to have no risk of default and a known return, they are the closest approximations that exist to the concept of a riskfree investment. For that reason, the return on Treasury Bills is taken as an approximation of the risk-free rate of return. • Commercial Paper Commercial paper is a short term promissory note issued by a corporation, typically for financing accounts for which payment is due to be received and for financing inventories. The maturity is usually 270 days or less. They are usually sold at a discount. These notes are rated by ratings agencies who report on the likelihood of default.

Money marketable securities • Negotiable Certificates of Deposit As for non-negotiable CDs, these are promissory notes on a bank issued in exchange for a deposit held in a bank until maturity. They entitle the bearer to receive interest. A CD bears a maturity date (mostly 14 days to 1 year), a specified interest rate, and can be issued in any denomination. CDs are generally issued by commercial banks. These CDs are tradeable with dealers making a market (meaning they buy and sell to give the market liquidity).

Money marketable securities • Repurchase Agreements A repurchase agreement involves a dealer selling government securities to an investor with a commitment to buy them back at an agreed time. The maturity is often very short with many repurchase agreement being overnight. They constitute a form of short term borrowing for dealers in government securities. The interest rate on the transaction is the difference between the selling and repurchase prices. They permit the dealer to attain a short position (a negative holding) in bonds.

Capital Market securities Capital market securities include instruments having maturities greater than one year and those having no designated maturity at all. In the latter category can be included common stock and, in the UK, consuls which pay a coupon in perpetuity. The discussion of capital market securities divides them into fixed income securities and equities. Fixed Income Securities Fixed income securities promise a payment schedule with specific dates for the payment of interest and the repayment of principal. Any failure to conform to the payment schedule puts the security into default with all remaining payments. The holders of the securities can put the defaulter into bankruptcy.

Capital Market securities • Bonds are fixed income securities. Payments will be made at specified time intervals unless the issuer defaults. However, if an investor sells a bond before maturity the price that will be received is uncertain. Bonds sell on accrued interest basis so the purchaser pays the price plus the interest accrued up until the date of purchase. If this was not done, sales would either take place only directly after coupon payments or else prices would be subject to downward jumps as payment dates were passed.

Capital Market securities • Corporate Bonds Corporate bonds are similar to treasury bonds in their payment patterns so they usually pay interest at twice yearly intervals. The major difference form government bonds is that corporate bonds are issued by business entities and thus have a higher risk of default. This leads them to be rated by rating agencies. • Common Stock (Equity) Common stock represents an ownership claim on the earnings and assets of a corporation. After holders of debt claims are paid, the management of the company can either pay out the remaining earnings to stockholder in the form of dividends or reinvest part or all of the earnings. The holder of a common stock has limited liability. That is, they are not responsible for any of the debts of a failed firm. There are two main types of stocks: common stock and preferred stock.

Capital Market securities • Preferred Stock Preferred stock also represents a degree of ownership but usually doesn’t carry the same voting rights. The distinction to common stock is that preferred stock has a fixed dividend and, in the event of liquidation, preferred shareholders are paid before the common shareholder. However, they are still secondary to debt holders. Preferred stock can also be callable, so that a company has the option of purchasing the shares from shareholders at anytime. In many ways, preferred stock fall between common stock and bonds.

Derivatives are securities whose value derives from the value of an underlying security or a basket of securities. They are also known as contingent claims, since their values are contingent on the performance of the underlying assets. • Options An option is a security that gives the holder the right to either buy (a call option) or sell (a put option) a particular asset at a future date or during a particularperiod of time for a specified price - if they wish to conduct the transactions. If the option is not exercised within the time period then it expires. • Futures A future is the obligation to buy or sell a particular security or bundle of securities at a particular time for a stated price. A future is simply a delayed purchase or sale of a security. Futures were originally traded for commodities but now cover a range of financial instruments.

Derivatives • Rights and Warrants Contingent claims can also be issued by corporations. Corporate-issued contingent claims include rights and warrants, which allow the holder to purchase common stocks from the corporation at a set price for a particular period of time.

Indirect investment • Indirect Investments Indirect investing can be undertaken by purchasing the shares of an investment company. An investment company sells shares in itself to raise funds to purchase a portfolio of securities. The motivation for doing this is that the pooling of funds allows advantage to be taken of diversification and of savings in transactions costs. Many investment companies operate in line with a stated policy objective, for example on the types of securities that will be purchased and the nature of the fund management.

Indirect investment can be done in a number of ways as follows: § § § Unit trusts Investment trusts Hedge funds These will be discussed in details with markets discussion.

Securities and Risk The risk inherent in holding a security has been described as a measure of the size of the variability, or the uncertainty, of its return. Several factors can be isolated as affecting the riskiness of a security and these are now related to the securities introduced above. The comments made are generally true, but there will always be exceptions to the relationships described. • • Maturity The longer the period until the maturity of a security the more risky it is. This is because underlying factors have more chance to change over a longer horizon. The maturity value of the security may be eroded by inflation or, if it is denominated in a foreign currency, by currency fluctuations. There is also an increased chance of the issuer defaulting the longer is the time horizon. Creditworthiness The governments of the US, UK and other developed countries are all judged as safe since they have no history of default in the payment of their liabilities. Therefore they have the highest levels of creditworthiness being judged as certain to meet their payments schedules.

Securities and Risk • • • Some other countries have not had such good credit histories. Both Russia and several South American countries have defaulted in the recent past. Corporations vary even more in their creditworthiness. Some are so lacking in creditworthiness that an active ”junk bond” market exists for high return, high risk corporate bonds that are judged very likely to default. Priority Bond holders have the first claim on the assets of a liquidated firm. Only after bond holders and other creditors have been paid will stock holders receive any residual. Bond holders are also able to put the corporation into bankruptcy if it defaults on payment. This priority reduces the risk on bonds but raises it for common stock. Liquidity relates to how easy it is to sell an asset. The existence of a highly developed and active secondary market raises liquidity. A security’s risk is raised if it is lacking liquidity. Underlying Activities The economic activities of the issuer of the security can affect its riskiness. For example, stock in small firms and in firms operating in high-technology sectors are on average more risky than those of large firms in traditional sectors.

Securities and Risk These factors can now be used to provide a general categorization of securities into different risk classes. • Treasury bills have little risk since they represent a short-term loan to the government. The return is fixed and there is little chance of change in other prices. There is also an active secondary market. Long-term government bonds have a greater degree of risk than short-term bonds. Although with US and UK government bonds there is no risk of default and the percentage payoff is fixed, there still remains some risk. This risk is due to inflation which causes uncertainty in the real value of the payments from the bond even though the nominal payments are certain. • The bonds of some other countries bonds may have a risk of default. Indeed, there are countries for which this can be quite significant. As well as an inflation risk, holding bonds denominated in the currency of another country leads to an exchange rate risk. The payments are fixed in the

foreign currency but this does not guarantee their value in the domestic currency. Corporate bonds suffer from inflation risk as well as an enhanced default risk relative to government bonds. • Common stocks generally have a higher degree of risk than bonds. A stock is a commitment to pay periodically a dividend, the level of which is chosen by the firm’s board. Consequently, there is no guarantee of the level of dividends. The risk in holding stock comes from the variability of the dividend and from the variability of price. • Generally, the greater the risk of a security, the higher is expected return. This occurs because return is the compensation that has to be paid to induce investors to accept risks. Success in investing is about balancing risk and return to achieve an optimal combination.

Recap Our earlier lectures have introduced us about investment analysis and defined the concept of a security. It has looked at the securities that are traded and where they are traded. In addition, it has begun the development of the concepts of risk and return that characterize securities. The fact that these are related - an investor cannot have more of one without more of another - has been stressed. This theme will recur throughout the book. The chapter has also emphasized the role of uncertainty in investment analysis. This, too, is a continuing theme.

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